US interest rates are going up. Futures markets expect the fed funds rate, which is now 2.2 per cent, to rise to almost 3 per cent by the end of next year. They believe this largely because the Fed has told them to do so. It has said that if growth and inflation turn out as expected it will raise the funds rate to just over 3 per cent by next December. Whether we should worry about this – and what we should do about it – depends heavily upon how bond markets react.
I say so for a simple reason. The yield curve (the difference between long-term and short-term interest rates) predicts recessions. When it inverts – with long yields below short ones – a recession follows. And if it doesn’t invert, growth continues.
My chart shows the point. It shows the gap between 10-year yields and the fed funds rate, lagged three years, plotted against the three-yearly change in US industrial production. The link might not look especially strong. But this is because the relationship takes a particular form. When 10-year yields fall below the funds rate, a recession follows: this happened in 1989, 1999-00 and in 2006-07.
It is not the case that the steeper the inversion the deeper the recession. The curve was more inverted in 1989 than in 2007 but the subsequent recession was less severe. Nor is it the case that more upward-sloping curves predict stronger growth.The curve wasn’t strongly upward sloping in the mid-90s, for example, but subsequent growth was good.
Instead, the relationship here is simple and binary. An upward-sloping yield curve predicts economic expansions and a downward-sloping one recessions. That’s all.
There’s a simple reason for this. To see it just consider why anybody would want to own a long-dated bond if it yields less than cash. Often, the answer is that they expect returns on cash to fall so that, over the lifetime of the bond, returns on cash will be poor. An inverted yield curve is therefore a sign that investors expect short-term interest rates to fall. And why might they expect such a thing? Because they expect an economic downturn. An inverted yield curve is, in this sense, a sign that the wisdom of crowds expects a recession. And in this case, the wisdom of crowds has been a better forecaster than professional economists.
This is no mere abstract economics. We know that equity returns have been strongly correlated with fluctuations in US industrial production. If the yield curve predicts output, therefore, we'd expect it to also predict equity returns.
And it does.
My table shows this. It shows changes in share prices and US industrial production in the three years after both inverted and 'normal' yield curves: I’m using monthly data since 1987, and measuring the yield curve simply as the difference between 10-year yields and the fed funds rate. The differences are huge.
For example, in the three years after the yield curve has been upward sloping, the S&P 500 has risen by an average of 36.2 per cent. But in the three years after an inverted curve it has on average fallen by more than 5 per cent. The All-Share index has risen by an average of 22.7 per cent in the three years after upward-sloping curves, but fallen by an average of almost 10 per cent in the three years after inverted ones.
| How the yield curve predicts | ||
| Three-year changes after the shape of the curve | ||
| Normal | Inverted | |
| S&P 500 | 36.2 | -5.3 |
| US industrial production | 7.3 | -3.2 |
| All-Share index | 22.7 | -9.6 |
| Construction | 25.8 | -12.4 |
| Engineers | 35.6 | 7.3 |
| Transport | 25.6 | -19.5 |
| Pharmaceuticals | 33.5 | 16.3 |
| Food producers | 21.6 | 5.6 |
| Utilities | 33.3 | 4.5 |
| Banks | 29.8 | -10.0 |
| IT | 60.2 | -14.5 |
| Based on monthly data since January 1987 | ||
Much the same is true for several sectors with especially big effects for transport, construction and IT stocks. As you’d expect, however, defensive sectors such as pharmaceuticals and utilities have held up relatively well after yield curve inversions.
For now, the US yield curve is still upward sloping, which augurs well for shares. (So, too, for that matter, does the fact that non-US investors have recently been net sellers of US stocks.)
But this could change. If bond yields fall as the fed funds rate rises next year the curve could easily invert. If, or when, this happens, we’ll hear sophisticated arguments about why this doesn’t presage a recession this time – just as we heard them in 2000 and 2007.
We should ignore such talk. The yield curve sends strong messages and for a good reason. We should heed them.
